The ins and outs of escrow

Q: If a property falls out of escrow for any reason and another buyer is available, must the first escrow be canceled before the other buyer can close? If the second escrow closes without regard for the first, is this a legal sale? --Nevergiveup

A: Your question creates an opportune occasion to define some terms that are commonly used in real estate, but are often misunderstood -- even by the people using them! So, let's get clear.

In some states, there are title attorneys who do title searches and handle closing or settlement. After the title search is conducted, buyer, seller, their agents and an attorney or two all sit around a table and exchange the buyer's check for the seller's keys, and voila -- the deal is done.

Everywhere else, though, escrow is a much more essential element of a real estate transaction. When a buyer and seller both sign the purchase contract, they are said to be in contract and the buyer is beholden to begin inspecting the property and securing her loan, while the seller is obligated to sell the property to the buyer, unless the buyer becomes unwilling or unable to close the sale.

Within minutes or days of the contract being signed, the real estate brokers or agents representing buyer and seller cooperate to "open escrow," opening an account for the transaction with an escrow company or settlement service, and providing the escrow company with a copy of the purchase contract, which includes a set of instructions to the escrow provider that are signed by buyer, seller and (usually) both brokers.

When explaining to real estate novices what escrow is, exactly, I point out that escrow is the solution to the problem of two strangers meeting up, one of whom owns hundreds of thousands of dollars' worth of real estate, and the other of whom claims she can access the cash to buy the property.

Who gives what to whom first?

Well, escrow companies (which are generally the same companies that provide title insurance policies to buyers and their mortgage lenders) solve this issue by serving as a neutral, third-party intermediary and depository.

The parties give everything to the escrow company -- buyer gives her deposit, mortgage bank gives the mortgage funds it is extending on buyer's behalf, seller gives the deed to the property, all to the escrow provider -- and the escrow company doesn't give anything to anyone unless and until everyone involved has met the conditions they agreed to in the escrow instructions.

The escrow company also runs the title search, collects all the bills that need to get paid out of the seller's proceeds -- including any mortgage payoffs -- and distributes funds to everyone at closing. In states where this is the norm, the buyer and seller may never actually meet each other!

Again, escrow is opened right after the contract is signed, usually by virtue of giving the escrow provider the buyer's deposit funds and a copy of the contract.

So, with that context, you can see why the terms "falling out of escrow" and "falling out of contract" are used interchangeably, but are not strictly identical.

One is legal, one more logistical. When a transaction "falls out of contract" and the seller has to find another buyer, this means the buyer cannot close the deal for whatever reason. She may have lost her job or not been able to qualify for the mortgage, or perhaps her inspections revealed condition issues she deemed unacceptable.

When a buyer either cancels the contract or fails to perform in a timely manner, legally authorizing a seller to cancel the contract (in some cases), the transaction has "fallen out of contract."

Most states have a form cancellation of contract that is signed by both parties, in most cases, but may only need to be signed by one, in some instances. Once the contract is canceled, the seller is legally free to sell the home to another buyer.

Normally, just as escrow is opened immediately after a transaction goes into contract, escrow is closed immediately after a transaction "falls out of contract."

However, closing escrow does require escrow instructions, signed by both buyer and seller, that expressly close the escrow account and instruct the escrow office how to dispose of any deposit or other funds they are holding, or a court order telling escrow what to do with the deposit money.